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Transfer Pricing
Enrique Rayon, Ph.D.
McGladrey LLP
Outline
• What is Transfer Pricing?
• Transfer Pricing Methods
• Documentation
• Project Phases
• Applicability Review of TP Methods
• Selected Benefits from performing a TP Study
What is Transfer Pricing?
• Transfer pricing, the determination of prices charged
by one affiliated company to another in intercompany
transactions, is increasingly becoming a focus of
international tax inspectors around the world.
• Tax authorities around the world are increasing
cross-border dialogues and transfer pricing
enforcement abilities and have shifted their focus
from large taxpayers to small and midsize taxpayers.
What is Transfer Pricing?
• Authorities are not limiting their focus to transfer of
tangible goods.
• Transfers of intangible assets, services and funding
are also increasingly being closely scrutinized.
Rationale for a Transfer Pricing Analysis:
Effects of a Non-Market-Based Structure
Foreign Jurisdictions United States
Economic Returns
Functions
Risks
Goal of Transfer Pricing Analysis:
Find the Right Economic Balance
Foreign Jurisdictions United States
Functions, Risks, Economic Returns
Transfer Pricing Exposure
US Distributor Example
7
Scenario 1 Scenario 2
Manufacturer Distributor Manufacturer Distributor
FOR CO US CO FOR CO US CO
Sales ($M) 60 100 65 100
COGS 40 60 40 65
Gross Profit 20 40 25 35
OpEx 15 35 15 35
Operating Profit 5 5 10 0
Op. Profit Margin 8% 5% 15% 0%
Units sold 1,000,000 1,000,000
Price per unit ($) 60 65
What is Transfer Pricing?
• Tax Risk
– Potential double taxation of intercompany income.
– Transfer pricing legislation almost always includes
a provision for the imposition of significant
penalties when adjustments are made to taxable
profits following an audit.
What is Transfer Pricing?
• Penalties – Substantial valuation misstatement, 20%
– Gross valuation misstatement, 40%
– Reporting penalties
• Failure to file Form 5471/5472
• $10,000 per occurrence
What is Transfer Pricing?
• Opportunity
– Effective transfer pricing can help minimize global
taxation.
– Adequate contemporaneous documentation of
transfer pricing strategy and implementation can
usually safeguard against the imposition of
penalties.
What is Transfer Pricing?
• Legislation
– Many countries follow the Organisation for
Economic Co-operation and Development’s
(“OECD”) guidelines.
– OECD and US legislation is based on the arm’s
length principle – related parties should conduct
business on arm’s length terms.*
* Arms’ length terms: terms that would result from the transfer of the same
property or services between two unrelated entities in similar circumstances.
Transfer Pricing Methods
• Two Approaches:
– Transactional analysis
– Profit based analysis
Transfer Pricing Methods
• Transactional Analysis
– Arm’s length prices are determined by comparison
with comparable uncontrolled prices – similar
transactions between unrelated parties.
Transfer Pricing Methods
• Profit Based Analysis
– Arm’s length prices are justified by comparison of
the enterprises profitability with that of comparable
uncontrolled legal entities.
Transfer Pricing Methods – US
• Relevant Methods (Best Method)
– Comparable Uncontrolled Price (CUP)
– Resale Price Method
– Cost Plus Method
– Profit Split
– Comparable Profits Method (CPM)
16
Transfer Pricing – Service Regulations
• (New) US regulations introduced the “services cost method” (SCM)
– Specified covered services
– Low margin covered services
• Rev. Proc. 2007-13 provides “evolving” list
17
Transfer Pricing - Service Regulations
• Services eligible for SCM (Rev. Proc. 2007-13) – Accounting and audit
– Tax
– Health, safety, environmental and regulatory
– Treasury
– Purchasing
– Information and technology
• Includes flexible, other “similar” activities category for each activity.
Transfer Pricing Documentation
• Documentation
– A key element of a transfer pricing strategy,
whether it is transaction or profit based, is it’s
documentation.
– The availability of contemporaneous transfer
pricing documentation is a fundamental
requirement of all transfer pricing legislation.
19
Global TP Documentation Challenges
Example
Transfer Pricing Documentation
• Documentation
– Both the US regulations* and the OECD
Guidelines include recommendations of what
documentation should be prepared.
* US documentation is regulated under U.S. Treas. Regs. § 6662.
US documentation must be contemporaneous with the tax filing.
Documentation will apply the Best Method rule (U.S. Treas. Regs. § 482).
• Documentation
Business overview
Organizational
structure
Agreements – if any
Method selected and
why
Methods not selected
and why
Controlled transactions
Comparables used
Economic and financial
analysis used
Data obtained after year
end
Index of documents
Transfer Pricing Documentation
22
Sample TP Project Phases
Include, but are not limited to:
• Phase I
– Fact-finding interviews
– Transaction and entity characterization, transfer pricing methodology
determination
• Phase II
– Analysis of defined transactions
– Transfer pricing benchmarking methodology development and application
• Phase III
– Local statutory documentation report for the Fiscal Year
– Implementation of transfer pricing policy; completion of intercompany
agreements
Functional Analysis
• Understand business and intercompany
relationships
– Analyze business functions and related party
transactions
– Define risks undertaken by each party
– Analyze economic conditions, contractual terms
and intangibles
• Business Functions
– Product design and
engineering
– Fabrication, extraction and
assembly
– Purchasing and materials
management
– Transportation and
warehousing
– Marketing and
distribution
– advertising, warranty
administration,
inventory management
– Managerial, legal,
accounting , admin
Functional Analysis
Functional Analysis
• Business Risks
– Market risks – fluctuations in cost, demand,
pricing, inventory
– Financial risks – exchange risk, interest rates
– Product liability risks
– Credit and collection
– Property ownership risks
– R&D successes and failures
• Intangible Assets
– Patents, inventions,
formulae, processes,
designs, patterns,
know-how
– Copyrights
– Trade marks and
trade names
– Franchises, licenses,
or contracts
– Methods, programs,
systems ,
procedures, surveys,
studies, forecasts,
customer lists,
technical data
Functional Analysis
Comparable Transaction or
Comparable Company Search
• Determine the most appropriate method and
select comparables
– Search for potential internal comparables; or
– Review private companies or publicly traded
companies using an appropriate database
Final Steps
• Perform economic and financial analysis.
• Prepare the contemporaneous
documentation report.
29
Sample ABC Co. Transaction Summary
ABC Co.
HK
ABC Co.
US
Payment for sales and marketing services
ABC Co.
DE
ABC Co.
CN
Payment for procurement and logistics services
Payment for purchases of products
ABC Co.
UK
ABC Co.
JP
30
CUP Method – Potential Applicability
ABC Co.
CN
ABC Co.
US/UK/DE/JP
Sales of products
Third Party Third Party
Third Party Third Party
Compare Prices
ABC Co.
US/UK/DE/JP ABC Co.
US/UK/DE/JP ABC Co.
US/UK/DE/JP
31
Resale Price Method – Potential Applicability
ABC Co.
CN
ABC Co.
UK
Sales of products
Third Party
Third Party
Compare Gross
Margins
32
Cost Plus Method – Potential Applicability
ABC Co.
CN
ABC Co.
US/UK/DE/JP
Sales of products
Third Party
Third Party
Compare Gross Margins
ABC Co.
US/UK/DE/JP ABC CO.
UK/UK/DE/JP ABC Co.
US/UK/DE/JP
33
CPM – Potential Applicability to ABC Co.- CN
ABC Co.
CN
ABC Co.
US/UK/DE/JP
Sales of
Products Comparable
Company
Compare
PLIs ABC Co.
US/UK/DE/JP ABC Co.
US/UK/DE/JP ABC Co.
US/UK/DE/JP e.g., NCP 5%
NCP Arm’s Length Range: e.g., 2% - 6%
Comparable
Company
Comparable
Company
Comparable
Company
34
CPM – Potential Applicability to ABC Co.- US
ABC Co.
US
Sales of
Products
Comparable
Company
Compare
PLIs
e.g., OPM 5%
OPM Arm’s Length Range: e.g., 2% - 6%
Comparable
Company
Comparable
Company
Comparable
Company
ABC Co.
CN
35
Selected Benefits to a Company from
performing a Transfer Pricing Study
• Impact on the bottom line through:
– Tax risk management
• Stricter enforcement of Transfer Pricing rules, greater penalty
risks
• FIN 48 / ASC 740
– Financial risk management (e.g., notes to the audited
financial statements)
• Better information flow / audit trail, improved internal
controls / tying of various systems and accounts
36
Other Potential Benefits to the Company
from the Studies
• Prospective analysis to set pricing
• Analysis to understand existing pricing strategy
• Optimize global effective tax rate
• Review existing pricing strategy and supply chain review
• Resolve global management issues
• Compliance with foreign documentation requirements
• Penalty protection
• Audit defense
• Basis for APA preparation
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